Use of the Installment Method in Liquidations (Part I)

This two-part article explores the use of the Sec. 453 installment-sale method by corporations and shareholders in complete liquidations. Part I addresses definitions, mechanics and Sec. 453's application to C corporations; Part II, in the next issue, discusses S corporations and some special situations.

Richard W. Harris, MBA, J.D., LL.M., CPA
Professor and Director, Graduate Tax Program
Grand Valley State University
Grand Rapids, MI

For more information about this article, contact Prof. Harris at harrisr@gvsu.edu.

Executive Summary

• A taxpayer recognizes income or gain on a liquidation as installment payments are received, using the GPR.

• Sec. 453B requires gain recognition on most dispositions of installment notes.

• Sec. 453(h) is applied separately to multiple blocks of stock.

   

The retroactive repeal of Sec. 453(a)(2)¹ (which had barred accrual-method taxpayers from using the installment-sale method) has refocused attention on the installment-method's benefits. In particular, Sec. 453(h) permits shareholders receiving qualified installment notes in otherwise taxable complete liquidations to use the method.

Part I of this two-part article, below, discusses shareholders' use of Sec. 453(h) and its effect on the distributing (accrual- or cash-method) corporation. Part II, in the next issue, examines the use of Sec. 453(h) by S corporation shareholders in actual and deemed asset sales and distributions of installment notes with original issue discount (OID).

The Installment Method

Sec. 453(b)(1) defines an "installment sale" as a disposition of property in which at least one payment is received after the close of the tax year in which the disposition occurs. According to Sec. 453(c) and Temp. Regs. Sec. 15A.453-1(b)(2), a taxpayer recognizes income or gain on a disposition as it receives installment payments,² using a gross profit ratio (GPR). Temp. Regs. Sec. 15A.453-1(b)(2)(ii) defines GPR as the ratio of the sale's gross profit to its contract price. "Gross profit" is defined by Temp. Regs. Sec. 15A.453-1(b)(2)(v) as the selling price,³ less the sum of the property's adjusted basis and selling expenses.

Under Temp. Regs. Sec. 15A.453-1(b)(2)(iii), "contract price" refers to the selling price, less the sum (not in excess of the seller's adjusted basis in the property, modified in some cases by commissions and selling expenses) of (1) all debt secured by the property and (2) certain other debt incurred or assumed by the purchaser on the property.⁴ "Payments" include all cash or other property actually or constructively received during the year, but not the buyer's evidences of debt (i.e., the installment note), even if, according to Temp. Regs. Sec. 15A.453-1(b)(3)(i), a third party guarantees such debt.

Example 1: In 2002, T sells a parcel of land with a $200,000 basis and $500,000 fair market value (FMV), subject to a $150,000 mortgage, for $20,000 and a five-year promissory note paying $66,000 annually beginning in 2003, plus 10% interest. T had held the land for investment. T's gross profit, contract price and GPR are $300,000 ($500,000 – $200,000), $350,000 ($500,000 – $150,000) and 85.714% ($300,000/$350,000), respectively. T's 2002 recognized gain is $17,143 (85.714% x $20,000); in 2003–2007, it is $56,571 (85.714% x $66,000) per year. T recognizes interest as ordinary income as received. T's total gain recognized is $300,000 ($17,143 + (5 x $56,571)).

According to Temp. Regs. Sec. 15A.453-1(b)(3)(i), if the property transferred is secured by debt (whether assumed or taken subject to by the buyer) exceeding the seller's basis in the property, the excess would be additional payment received in the sale year. The contract price is calculated by subtracting from the selling price the debt not in excess of such basis.

Example 2: The facts are the same as in Example 1, except that the mortgage is $275,000. The debt in excess of T's basis is treated as a payment in the sale year. The installment note is $205,000 ($500,000 – ($20,000 + $275,000)); the gross profit, contract price and GPR are $300,000, $300,000 ($500,000 – $200,000), and 100% ($300,000/$300,000). T recognizes $95,000 ($20,000 + $75,000) gain in 2002, and $41,000 ($205,000 note payable over five years) annually in 2003–2007. His total gain remains at $300,000.

Exceptions and Limits

The following items do not qualify for the installment method:

1. Dispositions of inventory and publicly traded stock (Sec. 453(b)(2) and (k)(2)(A) and Temp. Regs. Sec. 15A.453-1(b)(4)).

2. Depreciation recapture (Sec. 453(i)).

3. Demand notes, notes secured by cash (or cash equivalents) and readily tradable corporate or governmental obligations (Temp. Regs. Sec. 15A.453-1(e)(1)).

As discussed in Part II of this article, if an installment note's stated interest rate is inadequate, it might be deemed to include OID, resulting in imputed interest under Sec. 1274(a) or 483.

Under Sec. 453A(b)(2), if a taxpayer (together with certain related persons) holds at the end of a tax year more than $5 million in face value of installment notes that arose during the year, he would have to pay interest on the tax deferral. Under Sec. 453A(b)(1), if a taxpayer holds an installment note from a sale in which the sales price exceeded $150,000 and pledges it to secure a borrowing, the net loan proceeds would be deemed payments received on the note.

Finally, Sec. 453B requires gain recognition on most dispositions of installment notes.

Nonsubsidiary Complete Liquidation

Sec. 336(a) provides generally that a liquidating corporation recognizes gain or loss on a property distribution as if such property were sold to the distributee at its FMV. Under Sec. 331(a), amounts a shareholder receives in a complete liquidation are treated as full payment in exchange for stock (normally triggering capital gain or loss recognition). Under Sec. 334(a), if a liquidating corporation distributes property other than cash to a shareholder, the property's basis in the shareholder's hands would be its FMV at the time of the distribution.

Example 3: J owns all the stock of K Corp., a cash-basis C corporation with a $500,000 basis in assets, $300,000 in liabilities and a $900,000 FMV. J's stock basis is $120,000. K pays its creditors and liquidates, retaining $120,000 to pay the tax on the liquidation gain; it distributes the remaining $480,000 in assets. J's gain is $360,000 ($480,000 – $120,000). Her aggregate basis in the assets received is $480,000 (less any cash received).

    

Stock or Asset Sale?

A corporation can sell its business operation via a sale of stock or assets. With the 1986 repeal of the General Utilities⁵ doctrine, a stock sale is generally more advantageous for a C corporation; the selling shareholders may qualify to use the installment method. However, in some instances, a C or S corporation may be sold in an actual or Sec. 338(h)(10) deemed asset sale.⁶ Sec. 453(h) enables shareholders to use the installment method on the receipt of notes or other debt in a subsequent actual or deemed liquidation.

Sec. 453(h)

Under Sec. 453(h), a shareholder receiving certain installment notes in exchange for stock in a Sec. 331 liquidation can treat the receipt of payments (rather than receipt of the note) as payment for the stock.⁷ Moreover, under Regs. Sec. 1.453-11(a)(2)(i), the shareholder is treated as having received the installment note (1) directly from the person who issued it to the corporation and (2) in exchange for stock in the liquidating corporation.⁸

Accordingly, the shareholder reports gain on the liquidation under the installment method as distributions (cash and property) are received currently and as payments are received in the future.

Example 4: The facts are the same as in Example 3, except that K pays its creditors and sells its remaining assets for $120,000 and a $480,000 installment note. K then liquidates, distributes the note to J and pays the $120,000 tax on the liquidation. J's gross profit is $360,000 ($480,000 – $120,000), which will be recognized as she receives payments on the note. Her GPR is 75% ($360,000/$480,000); she will recognize a $360,000 total gain ($480,000 x 75%) on the note. Interest on the note is ordinary income as received.

Definitions

Sec. 453(h) does not change the gain the corporation or shareholder recognizes, but defers the shareholder's gain recognition. According to Regs. Sec. 1.453-11(a)–(c), Sec. 453(h) applies only to distributions of qualifying installment obligations to qualifying shareholders. A qualifying installment obligation is all of the following:

1. Not payable on demand or readily tradable (Regs. Sec. 1.453-11(c)(1) and Temp. Regs. Sec. 15A.453-1(e)).

2. Acquired in a sale or exchange of corporate assets by the liquidating corporation during the 12-month period beginning on the date the plan of complete liquidation is adopted (the liquidation must be completed during the 12-month period)(Sec. 453(h)(1)(A) and Regs. Sec. 1.453-11(c)(1)).

3. If attributable to a sale of stock in trade or inventory, results from a sale or exchange to one person in one transaction and involves substantially all of such property attributable to the corporation's trade or business (i.e., a bulk sale)(Sec. 453(h)(1)(B) and Regs. Sec. 1.453-11(c)).⁹

Regs. Sec. 1.453-11(b) defines a "qualifying shareholder" as a shareholder to which, as to the liquidating distribution, Sec. 331 applies. Thus, a creditor receiving an otherwise eligible installment note in exchange for a claim against the corporation does not qualify for the installment method under Sec. 453(h).

Under Regs. Sec. 1.453-11(a)(5), Example 2, absent an election out, if a shareholder receives, in a liquidating distribution, cash or other assets in addition to an installment note, he treats the entire transaction under the installment method. In such case, Regs. Sec. 1.453-11(a)(3) provides that the shareholder must include in his selling price all items received in the liquidation, including cash, the issue price (discussed in Part II) of qualifying obligations and the FMV of other property (including installment notes not eligible for Sec. 453(h) treatment). Under the installment method, the cash and other assets received in the liquidation (not including the qualifying installment note(s)) are treated as payments received, triggering gain recognition; gain attributable to the installment note is deferred until payments are actually received.¹⁰

Example 5: The facts are the same as in Example 4, except that J receives a $280,000 installment note, $100,000 and property with a $100,000 FMV. Her GPR is still 75%. She recognizes an immediate $150,000 gain ($200,000 x 75%) on receipt of the cash and property; she will recognize an additional $210,000 gain ($280,000 x 75%) as she receives payments on the note. Her total gain recognition is $360,000.

If a shareholder assumes a corporate liability (secured or unsecured) in the liquidation or takes property subject to a liability (including the corporation's liability for income tax attributable to the distribution), the Sec. 453(h) computations are performed after adding such liabilities to the shareholder's adjusted stock basis.¹¹ Thus, if the property distributed in Example 5 were subject to $40,000 of debt, J's stock basis would increase to $160,000 and her gain would decrease to $320,000. The contract price remains at $480,000; the GPR is 66.667% ($320,000/$480,000). Thus, in 2002, J would recognize $133,333 gain ($200,000 x 66.667%); $186,667 is deferred under the installment method ($280,000 x 66.667%).

Estimates and Allocations

When a shareholder receives (or anticipates receiving) liquidating distributions (including a qualifying installment note) in more than one tax year, he must reasonably estimate total expected distributions, allocate his stock basis to current and future distributions under such estimates and recognize the appropriate gain attributable to the distributions received each year.¹²

Under Regs. Sec. 1.453-11(d), if a shareholder anticipates receiving distributions in more than one tax year, reasonably estimates his total gain and recognizes the appropriate gain, but the actual distributions and gain differ from such estimates, he can either (1) adjust the calculations and gain recognition for the year the exact amount is determined (and future years, if any) or (2) file an amended return(s) to report the exact amount in the earlier (and subsequent) years.¹³

Example 6: The facts are the same as in Example 5, except that J reasonably anticipates receiving an additional distribution of $200,000 in 2003. J's total anticipated gain on the liquidation is $560,000 ($680,000 – $120,000). Her GPR is 82.353% ($560,000/$680,000), Thus, J's gain recognized in 2002 is $164,706 ($200,000 x 82.353%). If, in 2003, she receives only $150,000 as a final liquidating distribution (rather than $200,000), she might choose to adjust the gain calculations going forward. If so, her remaining gain to be reported is $345,294 ($630,000 – 120,000 – $164,706). J's revised GPR is 80.301% ($345,294/$430,000). Thus, J recognizes $120,452 gain attributable to the $150,000 cash received in 2003, and will recognize $224,842 ($280,000 x 80.301%) under the installment method as payments are received; her total gain recognition is $510,000.

Alternatively, J could opt to recalculate her entire gain for the liquidation and file amended returns; in such case, her gross profit, contract price and GPR would be $510,000, $630,000, and 80.952% ($510,000/$630,000), respectively. Her 2002 recognized gain would be recalculated as $161,905 ($200,000 x 80.952%). The 2003 recognized gain attributable to the receipt of $150,000 is $121,429 ($150,000 x 80.952%); the gain to be recognized in the future is $226,666 ($280,000 x 80.952%). Total gain recognition remains at $510,000.

Regs. Sec. 1.453-11(d) does not explicitly address cases in which reasonable estimates are not possible or the amount to be received under the installment note is uncertain. However, it appears that this regulation displaces the general rules under Sec. 453(j) and the regulations thereunder for recognizing gain on an installment note subject to contingencies.

A typical scenario is an "earn out" provision, in which a seller receives additional consideration if future performance targets are achieved. If Regs. Sec. 1.453-11(d) covers this situation, the recipient shareholder need only make a reasonable estimate of his total amount to be received in the liquidation. Thereafter, he would be able either to adjust his gain calculations each year as the facts unfold or file amended returns (similar to Example 6 and the accompanying text above).

However, if Regs. Sec. 1.453-11(d) does not cover an uncertain-amount situation, the contingent-installment-note rules would be used.¹⁴ The Service should offer further guidance to clarify this point.

Per-Share Basis

Regs. Sec. 1.331-1(e) requires that a shareholder compute liquidation gain or loss on a per-share basis. Thus, a shareholder owning blocks of stock with different bases and/or holding periods must compute a separate gain or loss for each. Sec. 453(h) applies to each block separately.

Example 7: M owns 1,000 shares (100%) of Z Corp., as follows:

In 2002, Z liquidates and distributes to M $500,000 and a $1,000,000 installment note that qualifies for Sec. 453(h) treatment. M's amount realized on the liquidation is apportioned pro rata among the three blocks of stock--$750,000, $375,000 and $375,000. Her resulting tax gain or loss on each block is a $700,000 gain ($750,000 – $50,000), a $275,000 gain ($375,000 – $100,000) and a $125,000 loss ($375,000 – $500,000). M can use Sec. 453(h) for the gains attributable to Blocks 1 and 2, and deduct the loss on Block 3 without regard to Sec. 453(h). Presumably, all Sec. 453(h) and installment-payment computations are made on a pro-rata basis. Thus, the first payment of $100,000 on the note is applied to Block 1 as follows: GPR 93.333% ($700,000/ $750,000) applied to the $50,000 received ($100,000 x 50%), for a $46,667 recognized gain ($50,000 x  93.333%).

Sec. 453(h) applies on a shareholder-by-shareholder basis, as shareholders can elect out. If a shareholder elects out or Sec. 453(h) does not apply, he must recognize gain and loss on the liquidating distributions (including the installment note) at FMV, under Sec. 331. According to Regs. Sec. 1.453-11(a)(3), an election out applies to all liquidating distributions to that shareholder; separate elections cannot be made for separate blocks of stock.

Finally, under Sec. 453(h)(1)(C), a shareholder who receives an installment note on which the obligor is his spouse or a controlled entity (within the meaning of Sec. 1239(c)¹⁵) is treated as having received full payment for his stock to the extent the note was received for the corporation's sale of depreciable property.

Distributing Corporation's Treatment

If a liquidating corporation is using the installment method, it must recognize any gain or loss attributable to the distribution of the installment note under Secs. 336 and 453B.¹⁶ The gain or loss is the note's FMV on distribution less its basis at that time, under Sec. 453B(a)(2). Sec. 453B(b) defines an installment note's basis as the excess of face value over the income or gain recognized if the note is satisfied in full.

Example 8: The facts are the same as in Example 4, except that K sells its assets for $420,000 and a $480,000 installment note payable in three equal annual installments of principal (plus adequate interest) beginning in 2003. K's GPR is 44.444% ($400,000/$900,000); it recognizes $186,667 gain ($420,000 x 44.444%) attributable to the cash received in 2002 and defers $213,333 gain ($480,000 x 44.444%) attributable to the note. If K distributes the note in liquidation after receiving one payment (and recognizing $71,111 gain ($160,000 x 44.444%)), K will recognize $142,222 gain ($320,000 x 44.444%) on the liquidation. A distributee shareholder may use Sec. 453(h) without regard to the note's basis in K's hands or the gain K already recognized on it.

If K elected out of the installment method (and recognized the gain (or loss) currently), its basis in the installment note would be the note's FMV at the time of the sale.¹⁷ Thus, no further gain or loss is recognized on the distribution of the installment note in liquidation (unless it increases or decreases in value between the time K receives it and distributes it to shareholders). In such case, Sec. 336 triggers recognized gain and (unless restricted by Sec. 336(d)¹⁸) recognized loss.

Conclusion

In the next issue, Part II of this article will discuss, among other topics, S corporation liquidations, OID and inventory sales.